Knowledge that Transforms

This study examines which financial stability responsibilities have been delegated to central banks (CBs), how these responsibilities are executed, and whether democratic accountability arrangements are in place. The results of our survey among all CBs in the OECD area suggest that there is no unambiguous definition of financial stability or systemic risk, and that, generally, the responsibility for financial stability is not explicitly formulated in laws. Moreover, there is considerable heterogeneity in the way CBs pursue the financial stability objective. Our results also suggest that the democratic accountability of the financial stability function of central banks is often poorly arranged.

We build a simple model of banking in the presence of macroeconomic shocks where the comparative roles of private and public monitors can be analyzed. This model provides endogenous justifications for prudential regulation (capital requirements) and emergency liquidity assistance by the Central Bank (lender of last resort). We show that market discipline can be helpful, but does not solve the fundamental problem of regulatory forbearance. We propose some directions of reform of the regulatory system that could improve the management of banking crises.

Drawing on a unique dataset of flow-of funds and balance sheet data, this paper analyzes the impact of financial crises on aggregate corporate financing and expenditure in a range of countries. Investment and inventory contractions are the main contributors to lower GDP growth after crises, with a much greater effect in emerging market countries. The debt–equity ratio is correlated with investment and inventory declines following crises. Econometric analysis suggests that financial crises have a greater impact on expenditure and the financing of corporate sectors in emerging markets than in industrial countries. Industrial countries appear to benefit from a pick-up in bond issuance in the wake of banking crises. Although companies in emerging market countries hold more precautionary liquidity, this is evidently not sufficient to prevent a greater amplitude of response of expenditure to shocks.

The paper provides a critical review of the Financial Services Agency (FSA) of Japan since its establishment in June 1998 (as the Financial Supervisory Agency) to June 2004. During the six year period, the FSA faced the challenge of addressing severe insolvency problems in banking as well as life insurance industries. The paper argues that the initial separation of the supervisory role (in the Financial Supervisory Agency and the Financial Reconstruction Commission) and the policy planning role (in the Ministry of Finance) was useful in the sense it allowed the FSA to have a firm stance on the insolvency problem that was partially created by the failure of the past financial regulatory policy. Even after the creation of the FSA, the Bank of Japan remained as another bank supervisor. This seems have made the central bank reluctant in relaxing monetary policy out of the fear that such loose monetary policy would actually discourage re-organization of banking industry. This suggests a problem of having the central bank as a bank supervisor. For the life insurance companies, the FSA (both old and new) has not been successful in intervening (using prompt corrective action) before the failures. Finally, the paper also points out the important role of the leadership at the FSA that shapes the financial regulation, and suggests a problem of appointing a politician to this role.

Emerging market economies have undergone an extraordinary period of turbulence in capital markets during the period 1997–2002, and volatility remains a salient feature of the financial landscape. This paper discusses a number of central issues for the future of the region's financial markets. It starts with a brief summary of the reforms undertaken and shows that financial systems still remain fragile in a number of countries in the region. The paper then advances policy recommendations to strengthen domestic financial systems. The analysis and policy prescriptions aim at three areas: 1) the appropriate design of regulatory and supervisory institutions; 2) the role of foreign banks; and 3) how international financial practices affect Latin America.

The purpose of our work is to explore contagious financial crises. To this end, we use simplified, thus numerically solvable, versions of our general model [C.A.E. Goodhart, P. Sunirand, D.P. Tsomocos, A Model to Analyse Financial Fragility, Oxford Financial Research Centre Working Paper No. 2003fe13, 2003]. The model incorporates heterogeneous agents, banks and endogenous default, thus allowing various feedback and contagion channels to operate in equilibrium. Such a model leads to different results from those obtained when using a standard representative agent model. For example, there may be a trade-off between efficiency and financial stability, not only for regulatory policies, but also for monetary policy. Moreover, agents who have more investment opportunities can deal with negative shocks more effectively by transferring ‘negative externalities’ onto others.

Recent initiatives to improve the public information about individual firms have brought to the fore significant differences in perspective between accountants and prudential regulators. We examine the reasons for these differences and propose ways in which they could be reconciled within a broader framework aimed at identifying the type of information conducive to the proper functioning and stability of the financial system. We argue that such information should concern three characteristics: estimates of current financial condition; estimates of risk profile; and measures of the uncertainty surrounding those estimates. So far, efforts have mainly focused on the first characteristic, with the second having drawn attention only recently and the third having been largely neglected. We propose a strategy to reconcile different perspectives based on two principles: first, in the long-term, the “decoupling” of the objective of accurate financial reporting by the firm from that of instilling the desired degree of prudence in its behaviour; second, a “parallel transition” process towards that objective so that at all points the prudential measures can neutralise any undesirable implications of changes in financial reporting standards on financial stability.